Five common circumstances where debt fund schemes can prove beneficial

The choice of a debt fund depends on the financial goal and its time frame. Here are five common circumstances where these schemes can prove beneficial.

1) Saving for a short-term goal

If you need the money in 6-12 months, go for ultra short-term or short-term debt funds. The returns of these funds are not volatile because they invest in bonds of very short maturities. Any change in interest rate does not affect them. You can expect a return that is comparable with those from fixed deposits of the same tenure.

While there is no difference in the applicable tax rate if you are withdrawing your investment within a year of investing, you do get the liquidity advantage, as also the flexibility of a mutual fund. You can also opt for a liquid fund for this purpose, but a short-term debt fund may be able to give you slightly better returns. Of course, the difference of 10-20 basis points in the returns should not matter if you invest for six to eight months. Do consider the exit load of the fund when you invest.

Nandkumar Surti, Managing Director & CEO, JP Morgan Asset Management

"Small investors should know about the longterm advantages of debt funds and leverage their benefits by investing in them

Need money at a very short notice

The tenure of the investment is not always fixed. Noida-based Feroz Mehmood (see picture) may need the money at a short notice if he comes across a good deal in real estate.

A liquid plan is best suited for goals with undefined tenures. These plans do not levy any exit load and the growth is slow and steady.

The most important aspect of these schemes is the safety of capital. Since the funds are invested in the call money market, there is virtually no chance of a default or credit risk.

There's also the liquidity they offer. If you redeem the investment before 3 pm, the money is credited to your account by 12 noon of the next working day. The returns are only a tertiary concern. In recent months, liquid plans have given decent returns comparable with FDs.

Debasish Mallick, Managing Director & CEO,IDBI Mutual Fund

"If you are undecided about the avenue you want to invest in, just put the money in a liquid fund and then evaluate your options."

Avoiding high tax on fixed deposits

The tax advantages of investing in a debt fund have already been spelt out in detail. However, income funds can give you more than just a low tax rate. In a scenario where interest rates are expected to go down, these medium-term debt funds stand to gain.

In the past 6-12 months, these funds have given returns that are at least 100-200 basis points higher than the prevailing fixed deposit rate. This is because of the inverse relationship between interest rates and bond fund NAVs.

By that logic, long-term funds may appear attractive, but they are also very volatile.

We recommend dynamic bond funds, which deftly change their average maturities according to the market trend. "Dynamic bond funds are the best option in these volatile times," says Mahendra Jajoo, executive director and head of fixed income, Pramerica Mutual Fund.

Harshendu Bindal, President, Franklin Templeton India

"Unlike small savings schemes, there is no limit on the amount an individual can invest in debt funds."

Large sum to invest in equity funds

The benefits of debt funds extend to equity investments too. Financial planners say that if you have a large sum to invest, you should not do it at one go, but in monthly SIPs.

However, if you put the money in a savings bank account, it will earn a piffling 4-6% interest. Instead, put it in a debt fund and then create a systematic transfer plan (STP) into an equity fund.

This is similar to an SIP, except that the money comes from the debt fund, not your bank account. This is possible only in schemes from the same fund house.

This means you must first identify the equity fund you wish to invest in and then put the money in a debt fund from the same fund house (see table). Some fund houses even waive exit loads on STPs.

Need regular income after retirement

The systematic withdrawal plan (SWP) is the reverse of an SIP and is best suited for retirees who are looking for a regular income from their investments. You can get an income from fixed deposits as well, but the big problem here is that this income is fixed in case of deposits. This poses a problem because expenses keep rising due to inflation.

If you need Rs 25,000 for monthly expenses in 2012, in three years, 8% inflation would push this up to Rs 32,000. By 2018, you will need Rs 40,000 a month. Debt funds allow you to customise the withdrawals through SWPs.